The National Plan for Water Security: Taking Over the Role of a Market?

Introduction

On January 25th 2007, the Prime Minister of Australia, Hon. John Howard, announced a 10 year, 10 billion plan to address the water problem in the Nation (Howard, 2007). This plan, prompted by the long-term general trend of increasing water scarcity in Australia, follows numerous other water initiatives, government programmes and decisions in recent years. All of these programmes were aiming, in one way or another, at increasing the efficiency of water use in Australian agriculture and most of them have proposed a market based system for water allocation. The key outcome from introducing a water market is to enable a ‘true’ price for water to be formed. Once the water is priced correctly[1], the users will take that price into account when making decisions about how to use the water resource. In the context of irrigation, the most important feature of a water market is that it imposes an opportunity cost on irrigators for any amount of water that is being wasted. In the presence of a well functioning market, every megalitre (ML) of water wasted translates into foregoing the opportunity to sell that ML to other water users.

In the last decade or so, the agricultural economics profession has expended a substantial amount of research effort to investigate a broad array of issues related to water, and in particular to water markets in relation to irrigated agriculture. These include the property rights structure that would be most conducive to an efficient water market (Brennan and Scoccimmaro, 1999), structuring such a market (Crase et al., 2000), the water market and related externalities (Heaney et al., 2006), the water products to be traded on the market (Goesh and Beare, 2004), and many more. This ‘economic’ approach to water, where water market plays a key role, seemed to have been much in favour with the current Commonwealth Government [2].

Despite this solid understanding of the economics of water and functioning water markets, as well as the initial practical steps in trading water (e.g. Watermove) (Brennan, 2006), we now witness a shift into a different direction by the Commonwealth Government. The proposed Plan does not seem to be fully aligned with the market approach, and indeed in some of its points is undermining what water markets were designed to achieve in the first place.

An additional shortfall of the Plan, as pointed out by Grafton (2007), is the lack of consideration of the opportunity cost related to the commitment of a substantial amount of public funding. While the public often perceives government’s monies to be coming ‘out of nowhere’, it is important to understand that committing funds for one purpose automatically means that those funds will not be available for other purposes (i.e. public funding is ‘rival’). Ten billion dollars of taxpayers’ money spent on water projects means that those billions cannot be spent on other things, such as climate change projects, improving education system, health or public transport systems, or just simply cutting back on taxes.

The aim of this paper is to point to the inconsistencies of the proposed National Plan for Water Security (the Plan) with the ‘market approach’ to resolving water issues, which has seemingly been the centrepiece of the government water policy in recent years. The paper focuses on a section of the Plan termed ‘Modernising Australia’s Irrigation Infrastructure’, because this section is the most ‘out of line’ with the market based approach to water allocation problems. The paper does not set out to criticise the Plan per se. It is obvious that there is at least a degree of social agreement that the situation with water availability and water use in Australia has to be resolved through some form of Government intervention. The Plan is aligned with that social sentiment and has therefore a significant degree of public acceptance. Instead, the paper aims to produce a simple set of policy recommendations that could help policymakers in reaching decisions about the allocation of the funds earmarked for the proposed Plan.

The National Plan for Water Security

The Plan consists of 10 key points.[3] These are grouped in five groupings according to the issues that they are addressing. The classification of the groups and individual items is provided in the Plan itself (Howard, 2007) and has been reproduced in Grafton (2007). Looking at the breakdown of the items proposed in the Plan, it becomes evident that the vast majority of the proposed funding will go towards irrigated agriculture. One particular aim of the Plan is to enable improvements in off- and on-farm water use efficiency. In the following sections we are looking at some incompatibilities of this aim of the Plan with the currently existing incentives that irrigators have in the presence of water markets, and in the light of the ownership structure of irrigation companies.

Improving on-farm irrigation efficiency

Production economics aspects

In irrigated agriculture, water is an input in the production process. Within the standard neoclassical economic theory framework, a profit maximising irrigator would use water as an input as long as the value of the marginal product derived from using water (the price received for the crop times the additional yield obtained as a result of applying the marginal unit of water) is greater than the cost of applying the marginal unit of water (Freebairn, 2003). Given that the yield responsiveness to irrigation and the prices for agricultural commodities are relatively unaffected by irrigator’s decisions, the key variable influencing how much water is going to be applied in irrigation is the cost of applying the water.

The ‘market failure’ for water: Inappropriate pricing

For many years the cost of using irrigation water in Australia has been dampened as a result of subsidising the irrigation industry, over-allocating water extraction rights, and inconsistencies in delineation of those rights. All of these effectively amounted to underpricing of irrigation water, where the irrigators were facing low costs for the water resource. Not surprisingly, devoid of any incentive to conserve water due to its low cost and ‘artificial’ abundance brought about by subsidised irrigation schemes, irrigators tended to choose water application techniques that were least costly to them. This typically meant that gravity based surface irrigation was dominant in the Australian irrigation industry.

‘Inefficiency’ of water use

Gravity based irrigation systems are frequently referred to as being ‘inefficient’. However, there is little peer reviewed literature to support this.[4] A key fact that is often ignored is that all irrigation systems always have to lose some water so as to enable appropriate management of the salt balance of the soil (Tanji, 1990), while some loses are unavoidable due to timing errors in application. These losses have been estimated to be between 10 – 47% of all water applied (rainfall and irrigation) (Christen et al., 2001). There are many studies on water use efficiency, but most of these concentrate on yield per volume of water (e.g. Zwart and Bastiaansen, 2004). Efficiencies measured in those terms have been gradually increasing in Australia due to improvements in crop genetics and agronomy.

In one of the few on-farm studies, Tennakoon and Milroy (2003) report irrigation efficiencies, defined as a ratio of evapotranspiration (ET) minus rainfall minus change in soil moisture, to total water pumped, of between 37 and 68% for cotton production in the period 1996 – 1999 in Eastern Australia. Other studies suggested that some improvements could be made by adjusting the on-field water management (Khan et al., 2004; Smith et al., 2005).

Most of the published data indicates that irrigation efficiencies in Australia are rarely above 60 – 70%. However, similar irrigation efficiencies are reported in other countries in the world, even in the countries that are universally recognised as being efficient in using water, such as Israel (Bos and van Nugteren, 1990; Rosegrant and Shetty, 1994). This suggests that efficiencies in Australia are not much different from the rest of the world and that some Australian farmers are as efficient as farmers in some of the most “efficient” countries in the world. This means that there are limited possibilities for quick technological gains which can be readily applied. In turn, this implies that the costs of conserving more water through further improvements of on-farm efficiency are likely to be quite high. Even the recently completed report on possible water savings options (Khan et al., 2004) commissioned by the Pratt Water Group indicates that possibilities for on-farm efficiency gains are relatively small. Only a large scale conversion to pressurised irrigation systems, and major technology change, can achieve large gains[5]. A contrasting argument is that increased efficiency will have to involve much more careful management and thereby additional labour (as suggested by Smith et al., 2005), which implies an increase in production costs rather than in capital expenditure.

The effects of water markets

As a result of low water prices that catered to the ever growing water demand in Australia, resource scarcity quickly increased in a mature water economy (Randall, 1981). In light of this, and given the large volume of water used in agriculture, it quickly became evident that water can be used elsewhere in the economy at much greater benefit.

These circumstances presented a clear opportunity for establishing a market in water use rights. The rationale was that if use rights can be clearly established and made tradable, it will create incentives for the holders of those rights to use water more efficiently in their own irrigation operations and to sell the residual on the market. This will be achieved by ‘correctly’ pricing water in the market, where the water price reflects its true scarcity.[6] The higher the water scarcity, the higher the water price, and thereby higher the cost of applying water in irrigation enterprises (or equivalently, the higher the opportunity cost of not selling water on the market). The irrigators would still use the same rule as before (use water until its value of marginal product is equal to the marginal factor cost), but since the cost of using water increases, and the value of the marginal product remains unchanged, less water will be used. This creates incentive for investing in more water efficient irrigation systems (sprinkler based, or drip systems). Several simulation studies have shown that under the standard assumptions of neoclassical economics this is likely to occur in an empirical setting (Lee et al., 2007). Thus, it would be expected that once a functioning water market is established, it will provide incentives for irrigators to install water efficient technologies on farms.

The potential effects of the Plan

The proposal of cost sharing with irrigators in investing in new, water use efficient systems under the Plan has several deficiencies. One is that in many cases it may be unnecessary to subsidise investment into efficient systems that would have occurred anyway. If the water market functions properly, than there are clear incentives for farmers to invest in irrigation systems that will use less water. In particular, it can be shown (Ancev et al., 2004) that irrigators will invest in a more efficient irrigation system up to a point where the benefits from water savings achieved through this investment[7] are just equal to the cost of investing.[8] In the presence of functioning water market, a rational irrigator would undertake an investment based on the above condition. Any subsidy from the government in the form of cost-sharing would only affect the distribution of resources (i.e. the irrigator would reduce their loan exposure), but would not change behavior, and is therefore not needed in majority of cases to induce adoption of the more efficient systems. Grafton (2007) points to the general cases where government assistance would be justified, and shows that those cases are not likely to be numerous.

Another potentially perverse effect is coming from the proposition in the Plan that water savings obtained as a result of the government support for investing in efficient irrigation systems be split 50-50 between the government and the irrigator. The 50-50 split makes economic sense only for an extremely small proportion of the irrigators for whom it just so happens that the private cost of investing in an efficient irrigation system are just lower than the half of the private benefits of doing so. For others, investing on their own, and reaping all the benefits may be a better outcome. Yet for others, not investing in an efficient irrigation system might be a preferred outcome, irrespective of the availability of government assistance. The ‘optimal’ split between the government and the private irrigators is specific to each irrigator and ranges from 0% to 100%. Averaging it out to 50-50, may make political sense as a fair proposition, but does not make economic sense in the majority of cases.

The financial assistance directed to increase on-farm water use efficiency foreshadowed by the Plan may also provide perverse incentives for expanding agricultural area under irrigation. This may come as a result of the effective reduction of the irrigator’s cost for installing more efficient systems, which will be brought about by the Plan. As government contributes to the cost of a new, more efficient irrigation system, the irrigators will experience subsidised cost for the water that is saved. This may lead irrigators to expand the area under irrigation as a result of being able to use the new, subsidized irrigation system. This outcome is undesirable, and is inconsistent with the idea of reducing water use in agriculture and leaving more water in the water bodies to support their ecological and environmental functions.

Improving delivery system efficiency

One other key aim of the Plan is to address water losses in conveyancing and delivery. The Plan operates with current estimates for such losses between 10 and 30 %. This is expressed as the percentage of water diverted from rivers for irrigation purposes that does not reach the farm gate. Some economic studies have found that explicitly distinguishing between withdrawal demand and delivery demand (the difference being comprised by off- farm conveyance losses) has important implications for the price elasticity of water demand by irrigators (Scheierling et al., 2004).

While the Plan does not cite any source on which the information about the delivery losses is based, there is some literature that indicates such losses exists (e.g. van der Lely, 1993; Khan et al., 2004; Meyer, 2005). The losses in conveyancing and delivery occur mainly due to evaporation and seepage. Seepage losses can have both positive and negative effects. The negative effects are well documented, e.g increases in salinity due to seepage losses that mobilise salt and contribute to raising local groundwater tables. However, some of these losses could maintain important ecosystems, particularly along rivers and irrigation channels. Many major supply channels have been constructed on sandier, but topographically higher prior streams or old flood ways (van der Lely 1993). As these flood ways naturally operate and lose water to recharge local groundwater tables and support specific vegetation, management of losses needs to be considered carefully.

Given that the Plan proposes to spend $3 billion on reducing conveyance and delivery losses, from the current estimated average of 25% to a projected average of 5%, and that the projected savings are to be shared on equal basis between the Commonwealth and the irrigators (who are supposed to contribute additional $0.75 billion) the question arises as to the economic logic behind the proposal. Even though arguments can be made about the public good nature of the irrigation channels, i.e. non-rivalry up to the point of congestion, it is not immediately clear why the irrigation companies themselves should lack incentives to improve efficiency in water delivery. This question is especially valid when it is known that many irrigation companies in Australia are effectively operating under the publicly owned corporation structure, and individual irrigators are shareholders in those corporations. Thus, given this ownership structure there should be incentives at both the corporate level and at the shareholder level to reduce water losses in conveyancing and delivery.

This implies that the proposal under the Plan to invest in improvement of conveyancing and delivery infrastructure may contradict with the incentives that are in place under the current ownership structure. One incentive incompatibility is that losses are presently not attributed to individual irrigators and are effectively subtracted from a common pool of water. Individual shareholders are getting what they receive at the farm gate, and only this quantity is accounted for by them. However, the sum of water received by all irrigators does not equal what is being delivered, the difference amounting to the conveyance loss. A portion (50%) of the benefit of reducing this loss will accrue to irrigation corporations, and will be up to them to decide whether to sell the extra water, leave it in the river for the environment, or “pay dividends” by increasing the water allocation to individual irrigators / shareholders. Since substantial benefits will be accruing to the irrigation corporations, then they should be valuing those benefits against the cost of investing in reduction of losses. If net benefits are positive, the irrigation corporations should be investing in projects that reduce conveyance losses without government assistance. Government assistance will only be justified in the cases where public benefits from reducing conveyance losses are greater than the public costs, and where incentives are not strong enough for private investment to occur. As Grafton (2007) shows, these cases are not likely to be numerous.

Conclusion and policy recommendations

While there evidently exist certain degree of social agreement that the problem with water availability, allocation and use in Australia needs to be addressed through some form of government action, the findings in the economic literature suggest that such action has to be accountable, rational and cost-effective. The proposed National Plan for Water Security, while representing a bold move in the direction of addressing water shortage problems, lacks some of these attributes and could be improved by taking into account economic arguments presented in this paper. In particular, the section of the Plan that addresses improving on-farm water use efficiency can benefit from further scrutiny, in the context of incentives currently in place and the distortion of those incentives under the proposed Plan. Based on the discussion in this paper, the following general suggestions can be put forward:

Government should not invest in projects aimed at improving water use efficiency based on catering to special interests, or based on attempting to be equitable to all irrigation regions in Australia. The key principle should be to invest in projects where public investment is necessary to induce change, and where incentives brought about by water markets are not strong enough to ensure private investment in improvement of on-farm irrigation efficiency. As has been shown here and elsewhere (Grafton, 2007), such cases are not likely to be numerous.

As an additional general principle, investment should be made in projects that bring most water savings per dollar invested (spent). Investment in such projects can be pursued through a ‘benefit sharing’ arrangement between the government and irrigators, but those arrangements should not be based on a uniform 50-50 share proposition, but should rather be tailored according to the specific situation of individual irrigators.

While property right structure pertinent to the conveyance and delivery of water is conducive of suspicions of ‘market failure’ due to a form of ‘common pool assets’, there is no case for generalisation across irrigation districts in Australia. The matter of fact is that many irrigation districts are organised as corporations with individual irrigators being their shareholders. In those cases, and provided that water markets are functioning properly, the irrigation districts should have the incentives to reduce losses in coveyancing and delivery on their own. Similar to the situation with on-farm efficiency, government assistance in those cases is not necessary to induce change in behaviour. Private incentives provided by the water market are sufficient for changes to occur. For those irrigation districts where infrastructure is owned by the public, government investment in reducing conveyance losses would be justifiable in the case where substantial benefits would accrue to the public. In such cases, a rigorous benefit-cost analysis will be required to determine whether individual projects are worthwhile to undertake.

Politicians often tend to commit public funds to proposed policies so as to make them credible. However, greater commitment of public funds does not automatically translate into a better economic or environmental outcome. The opportunity cost of committing these public funds should always be in the back of our minds. Instead of spending the funds on water projects, they might be better spent on some equally or indeed more important projects.

* Ancev (t.ancev@usyd.edu.au) is with the Discipline of Agricultural and Resource Economics, and Vervoort (w.vervoort@usyd.edu.au) is with the Discipline of Sciences, Faculty of Agriculture, Food and Natural Resources, The University of Sydney.

[1] Of course, as Bennet (2007) points out, the true or correct price for water has to take into account the values that community places on its non-extractive uses, including active and passive use environmental values.

[2] This was apparent in the then Parliamentary Secretary, and currently Minister for the Environment and Water Resources, Hon. Malcolm Turnbull’s interview on ABC-TV Lateline in October 2006, (ABC, 2006)

[3] It is interesting how political amenability is emphasised by using nice round numbers, such as 10 points, 10 billion, 10 years, 50/50 share, etc. It is not at all clear that these are justified on economic, scientific, or any other grounds.

[4]In general, the term “inefficient” has been interpreted as “losing water”, and water is generally considered “lost” if it is not anymore in the management system. Hence, the use of terms “conveyance losses”, “deep drainage losses”, “transmission losses”.

[5] Such a conversion would have to involve not only a conversion “on the field”, but also in the on-farm storage and delivery systems to make significant gains, as furrow irrigation, when well managed, can be as efficient as drip or overhead systems (Constable et al., 1990)

[6] Admittedly the true water scarcity needs to include the ‘environmental’ demand for water, which can not be reflected in the market if the ‘environment’ itself is not a market participant. This needs to be carefully taken in consideration when analysing the effects of water market.

[7] Either the market value of saved water, or the value of the saved water in production. The two values should be the same in equilibrium.

[8] Annual cost of servicing a loan that will cover the purchase and installation of the new irrigation system, plus any difference in cost of operation and maintenance between the existing and the new irrigation system.